One of the dilemmas of contemporary money management is whether it is feasible, or worthwhile, to attempt to outperform broad-based financial indices (typically equity or debt indices) in managing a core portfolio over time. This question is of particular importance to institutional money managers who are typically evaluated on the basis of their performance compared to a broad-based market index. One aspect of this question has been whether the addition of non-traditional investment components to a traditional portfolio of stocks and bonds can reliably improve the risk/reward ratio of a portfolio by diversifying a portion of such portfolio into assets likely both to perform positively over time and in a manner generally non-correlated with the general debt and equity markets.
Financial products have increasingly emphasized the value of diversification. Modern Portfolio Theory has demonstrated that over time a diversified portfolio, by reducing the incidence of major drawdowns, can generate high cumulative returns with reduced volatility (a commonly-used measure of risk), as compared to conventional portfolios consisting of stocks and bonds. “Non-traditional” investments are incorporated into an investment strategy because they are likely to demonstrate a significant degree of performance non-correlation to a “benchmark portfolio,” typically the general equity and/or debt markets. By combining non-traditional and traditional portfolio components, an “efficient frontier” of investment performance can be developed in which the addition of the non-traditional component increases returns while also reducing volatility up to the point of the desired level of portfolio efficiency (risk/reward ratio) and maximum non-traditional exposure. In the case of instruments of the present invention, the “efficiency” of the instruments designed pursuant to the invention is in large part a function of the extent to and consistency with which they outperform the selected financial benchmark.
One of the difficulties in implementing the diversification strategy of Modern Portfolio Theory has been to identify a reliably non-correlated and positively performing non-traditional investment instrument or class. Diversifying into a non-traditional investment can reduce volatility but not ultimately benefit a portfolio if the non-traditional investment is not profitable. In addition, many non-traditional investments have not, in fact, proved to be non-correlated with the broader markets, especially during periods of market stress (when the risk control benefits of diversification are potentially of the most importance).
Modern Portfolio Theory was developed in the 1950s. In the early 1960s, published financial portfolio research demonstrated that managed futures might serve as a non-traditional “asset class” for purposes of diversifying a traditional portfolio in a manner consistent with the tenets of such Theory. Since that time, while futures/commodities have been increasingly accepted as a means of diversifying traditional portfolios, the dominant approach to incorporating futures into a portfolio has focused on the use of managed futures—futures accounts actively managed by professional “Commodity Trading Advisors” and “Commodity Pool Operators.” The futures markets provide efficient and leveraged access to a wide range of potentially non-correlated assets. However, the performance of managed futures products has been unreliable. Whether managed on a discretionary basis or pursuant to computer models, actively managed futures strategies have demonstrated significant periods of under-performance. Furthermore, even when a managed futures investment is successful, it is impossible to predict with any confidence what its likely near- to mid-term performance will be. This uncertainty means that it is impossible to know whether any given non-traditional investment will be (1) profitable and/or (2) non-correlated with an investor's benchmark portfolio.
A related impediment to the efficient implementation of Modern Portfolio Theory investment products through the use of non-traditional investments is that non-traditional investment portfolio managers typically regard both their strategies and their market positions as proprietary and confidential. Uncertainty of performance is combined with uncertainty as to holdings and methods of strategy implementation. These uncertainties have caused many institutions (especially those which believe that their fiduciary obligations to their investors or beneficiaries require that they have access to position data) to avoid non-traditional investments. The “entry barrier” of not providing trade transparency is heightened because most actively managed non-traditional strategies are subject to a non-quantifiable “risk of ruin”—the possibility of sudden and dramatic losses of a large percentage of an overall portfolio. In today's market environment, this is a particularly topical concern due to the massive and wholly unexpected losses suffered by a number of non-traditional, “hedge funds” in 1998, many of which had previously exhibited excellent risk/reward characteristics. “Risk of ruin” is not generally considered to be a component of traditional equity and debt investments, and can be best monitored by “real time” knowledge of strategies and positions.
Finally, non-traditional investment alternatives are frequently highly illiquid. Many non-traditional strategies have a statistically significant incremental likelihood of success the longer the time horizon of the strategy cycle. This is especially the case with relative value, quasi-arbitrage methodologies but is characteristic of many non-traditional approaches. As a result, many non-traditional investments require investment commitments of 12 months or longer, eliminating investors' ability to limit their losses or adjust portfolio exposure by terminating or reducing their investment.
The present invention provides a non-traditional investment instrument which eliminates the illiquidity and trade non-transparency, as well as a substantial component of the unpredictability, of many alternative non-traditional investments and which has produced consistently successful and non-correlated performance over 38 years of researched price histories.
The present invention is directed in particular at combining a swap instrument which achieves full exposure to a benchmark index and a structured note which adds to the overall unitary instrument structured pursuant to this investment both (i) an incremental exposure to the selected benchmark index, plus (ii) exposure to a passive, long and short, commodity index. The incremental exposure to the benchmark index provides the potential to outperform this index in favorable periods, while the commodity index exposure provides potentially valuable diversification benefits by providing access to a non-traditional exposure which avoids or reduces the illiquidity, trade transparency and unpredictability typical of actively managed non-traditional investments.
Many traditional money managers are evaluated in large part on the basis of their ability to match or exceed a benchmark index. Instruments of the present invention provide such managers with full exposure to their benchmark index through a swap on such index, plus incremental exposure to such index through the component of the structured note which is itself keyed, in part, to such index, while also providing an exposure to a passive commodity index of long and short positions. The incremental benchmark index exposure can permit instruments of the present invention to outperform the benchmark index when it is moving upwards. In fact, it would only be if the passive commodity index not only underperforms but incurs losses equal to or in excess of the incremental benchmark exposure that the unitary instrument would not outperform. In addition, the passive commodity index component of the structured note, by providing diversification from the index, provides a return which can permit the instrument to perform profitably when the index is declining, potentially contributing significantly to cumulative outperformance of the index by the unitary swap/structured note instrument. The use of the structured note also limits the overall risk of instruments of the present invention, as the structured note assures the investor the full return of the principal invested in such note after a specified period of time.
In historical simulations, the combination of a swap on one preferred embodiment of the selected benchmark for the invention—the S&P 500 Stock Index—and a structured note combining a 20% incremental exposure to the S&P 500 plus an exposure of 100%-150% to the Mount Lucas Management Commodity Index (percentage figures, in each case, are of the total amount invested in the instrument) has outperformed the S&P in all rolling 8 year periods (the duration of one preferred embodiment of instruments of the present invention) since 1961 to a significant degree.